Measuring the Effects of the Business Cycle on the Federal Budget

June 23, 2009

Today CBO released an updated report on theeffects of the business cycle on the federal budget.

For example, during recessions, the budget deficit tends to increase because of the automatic stabilizers built into the budget: tax revenue tends to decline and certain forms of government spending, such as outlays for food stamps and unemployment benefits, tend to increase.

A budget measure that filters out cyclical factors is useful in several ways. For example, some analysts use such a measure to discern underlying trends in government saving or dissaving (that is, surpluses or deficits). Others use it to approximate whether the influence of the budget on aggregate demand and on the growth of real (inflation-adjusted) income in the short run is positive or negative. More generally, the measure helps analysts estimate the extent to which changes in the budget are caused by movements of the business cycle and thus are likely to prove temporary. The usefulness of the cyclically adjusted budget measure for such purposes is hampered by large but temporary federal measures, such as the Troubled Asset Relief Program (TARP).

Under CBOs baseline assumptions, the cyclically adjusted budget deficit will rise sharply in 2009, to 9 percent of potential GDP (from 2.6 percent in 2008), but then decrease in 2010 and 2011 to 4.7 percent and 2.2 percent of potential GDP, respectively. Those deficits are smaller than the unadjusted deficit estimates because the latter include the automatic responses of revenues and outlays to the current recession. CBO expects that economic output will be much farther below its potential level in 2009, 2010, and 2011 than it was in 2008, which is to say that effects of the business cycle will substantially increase the federal budget deficit in those years. According to CBOs baseline projections, in 2009 and 2010 the cyclical contribution to the budget deficit will climb to roughly 2.1 percent and 2.6 percent of potential GDP and in 2011 it will decrease to 2.2 percent.

Budget Deficits and Surpluses as Percentage of Potential GDP

Budget Deficits and Surpluses as Percentage of potential GDP